The sequence of returns risk (SORR), or sequencing risk, is the risk that you will be unlucky and have lousy returns while at the peak of your invested capital. That could lead to portfolio failure and hitting the Fancy Feast before your taste buds die. SORR risk is caused by cash flows into and out of a portfolio and is accentuated by volatility. We can manipulate these two variables to mitigate sequencing risk.
I previously reviewed some asset allocation strategies to mitigate SORR. Of course, that comes at a cost. Reducing the sequence of returns risk by stabilizing volatility using bonds also lowers the expected returns. Unfortunately, lower returns could also lead to running out of money. Further, for most people, behavioral risk is a more important driver than SORR when considering a portfolio’s bonds allocation.
This week, let’s look at the other way to mitigate SORR. Flexible Cash Flow.
Cash flow is what causes SORR.
Dollars invested are exposed to the returns that follow (missing the ones before) and dollars removed miss the future returns.
The biggest risk is that you need to take money out when the market is at the low of a major bear market and miss the ride back up. That lost capital doesn’t grow into the future and leaves you with less moving forward. So, it makes sense that if you can minimize taking money out in a bear market that you decrease the sequence of return risk.
A bear market bites hardest in the years right after retirement when your capital is at its greatest. A 30% drop for a $1M portfolio is $300K. Much more than if it were a $100K portfolio and a $30K drop. We spend actual dollars to live, so the change in absolute dollars is what matters.
Flexible cash flow mitigates SORR.
If we need a fixed amount of money from our portfolio to live off of, then we must take it out. Even if it is at a market low. We are at the mercy of the sequence of returns. On the other hand, if we can decrease our portfolio draw for that bad bear market year it mitigates the sequencing risk substantially.
Let’s use the same model as the previous posts on sequence of return risk. For the 30 year accumulation period, $25K/yr is invested. They then retire and draw $128K/yr for another 30 years before they die. They are unlucky and experience a 30% bear market in their first year of retirement. That would have them hitting the Fancy Feast for about 3 years before they hit the dirt. On the other hand, if they decreased their draw during that bad first year by 25% to $96K – then they would run out of money on their deathbed instead.
One year of moderately less cash withdrawal translated into 3 years of not being totally broke. That is a pretty powerful impact and shows that a minor course adjustment early on makes for a radically different destination.
So, how could they adjust to decrease their withdrawal rate for that year?
Spend less, earn something, or borrow temporarily. That sounds kind of trite. However, when we unpack it, I think that there are some interesting strategies to do this in practical terms.
Have some fat stores.
To do this, we need to plan to have some fat in our retirement budget. That is a problem for those who are planning to lean-FIRE with minimal discretionary spending on luxuries. Those planning to fatFIRE have some extra.. uh.. cushioning.
There are also periodic larger expenses that we may have some flexibility about when exactly to incur them. For example, a new vehicle, home renovation, or trip.
Use some of your human capital instead.
Money is used to exchange between time/effort/comfort (human capital) and our financial capital. If we are retired, we may have more time and energy to do things that we would otherwise pay for. Perhaps, do the home renovation yourself. Cook for yourself more. Build or fix things instead of paying someone else to. Besides the financial aspect, learning and using new skills helps with healthier aging. Doing this with family or friends, even more so. Preserve financial capital and build human capital at the same time.
Earning something using a Work Glide Path.
I actually think that this is likely one of the best options for the high-power professional. Instead of a glide path changing asset allocation into retirement, this is a glide path changing how we work into retirement. A “work glide path“. This not only attenuates sequence risk, but it also has other psychological benefits.
You may not need to earn much.
If you have a healthy fixed income allocation, then that is a source of money to tap. The amount you need to earn on top of that to bridge the spending gap may not be much. Also, many of our expenses in early retirement are likely to be less.
When working full time, we have all sorts of other expenses from working. They can be direct (like transportation) or indirect (like hiring a cleaner or ordering meals to make up for less available time/energy). Since we have arrived at our destination, the extra money required to fund RRSPs, TFSAs, or other retirement accounts is less or eliminated. Income taxes are also an expense of working. The taxes on the higher earned-income levels during our earning/saving years are usually much more than what we’d pay on the investment income from our portfolio.
Working has non-financial benefits.
Work feeds us in many ways. The right work in the right dosage feeds our need for activity, sense of purpose, sense of self, and our relationships.
Activity and Purpose.
There are some people who have sedentary passivity or napping as their super-power. However, most cannot just sit around or spend all of their time on leisure. They need a sense of purpose. That means that they are putting time/effort into something important. Most high-income professionals or successful business owners did not get that way through sloth. Purpose and activity are inherent parts of their lives and they’d be driven them nuts in their absence.
Sense of self.
One of the questions that Crispy Doc asks in his Docs Who Cut Back series is about how much of our identity is wrapped up in medicine. I think that it is much more than many of us are willing to admit. Even me. Medicine has been a huge part of most docs’ lives for many years and it is a rewarding and generally respected pursuit. It even changes our surname from the usual Mr/Mrs/Miss/Ms. I suspect that most career-oriented people have their careers form a significant part of their identity. They may experience loss and disorientation if they end that relationship abruptly, rather than phase it out.
The hospitals or other institutions that we work within won’t love us back. Having some emotional separation from them helps to stave off the bitterness of unrequited love. However, we do form many treasured relationships with the people at work. Colleagues, other co-workers, and patients. It is a major social outlet for many people. Again, weaning off of that while forming new relationships may be better than a quick divorce.
Work doesn’t have to be all or nothing.
Most high-income professionals, like doctors, have very valuable skills and experience. The personal cost sunk into honing them is one reason why many find it hard to move on. While they may not have the capacity or desire to use them fully as they age, they could make a very valuable contribution in a part-time, casual, or less demanding role. There are plenty of physician side hustles out there.
Borrowing temporarily to bridge a bad sequence of returns.
Another way to avoid drawing on a portfolio during a bear market is to borrow the money from somewhere else instead. That is functionally the same as leveraged investing. So, it needs very careful consideration before embarking upon this path.
Factors to consider before borrowing:
- What rate can you borrow at?
- Can you stomach the debt?
- Can you easily pay it back? Over what timeframe?
What rate can you borrow at and from where?
Interest rates in a downturn.
On the positive side of the equation is that if equities are tanking, the interest rates usually are too. Central banks use this lever to try to stimulate people to borrow money to spend and re-ignite the economy in a downturn. Rates will usually be lower than the long-term expected returns. I am not talking about credit cards and high-interest consumer loans. Those are never a good idea to carry. I am talking about a low-interest loan around the prime lending rate.
Of course, you need collateral to access a low-rate money.
Borrowing against falling assets like investment accounts or possibly real estate may not fly. Banks may be calling in loans made against investments in this environment. Margin loans and home equity loans (HELOC) are callable by the lender at any time. Margin loans tend to get called when markets crash – bad timing. For a HELOC, the psychology of borrowing against your house is very emotionally stimulating (in a negative way) and increases risk. Imagine you see your portfolio continue to drop and you have also borrowed against your house. The feeling that you may lose it all is not a good feeling.
Still, some with a lot of home equity and deep enough pockets to pay it off if needed, a home equity LOC may be an option. However, those are likely the same people who don’t really need to worry about sequencing risk anyway because they have lots of financial buffer.
For those with some whole life insurance, this might be one of the uses.
As stated elsewhere in the blog, for most people, whole or permanent life insurance is not a great investment vehicle. However, there are some people with large estates who could use some for estate planning or as a way to hold extra “fixed-income-like” assets in their corporation. Again, these are likely not people who need to worry about sequencing risk. However, if they have the policy anyway – borrowing against its cash value to decrease sequencing risk from an unlucky bear market may be a good option.
If using leverage, you need a plan.
This is vital. The mathematics of using leverage for long-term investment plans usually work out. However, leverage also magnifies the emotions that drive us to deviate from the plan and changing the math. Execution risk. To minimize that, you need a plan that factors in expected or probable events. Such as protracted bear markets.
Personally, I would plan to not exceed amounts of money that I could easily repay. It is less scary. I would need to know that “I will be ok no matter what” because there is a significant chance that I could see my investment accounts shrink further before they recover. If there were an unlucky market drawdown in my first year of retirement that triggered me to use leverage, then I would have no idea how deep it was going to go. ?30% ?40% ?50%. No idea. But, I would want to consider the worst-case scenario.
You would also need to consider over what time-frame that it would be easy to repay. As my Investin’ Intestinal Fortitude Testor exercise (mobile or tablet/desktop) illustrates, a bear market can last years, permeates our environment, and even our personal lives. I would want to factor that into my tolerance. I would plan on a loan that I could easily repay over a few years at most.
Flexible cash flow allows us to attenuate SORR by avoiding taking money out of our portfolio in an unlucky downturn during the period of highest risk (around retirement). A small change can have a large impact.
Using a “work glide path” around retirement to wean off of the non-financial benefits of work seems the best route for me. Others may prefer a different combination of spending less or earning income in an alternate way. Using debt as a temporary bridge may be possible for some. However, that comes with its own pitfalls and risks – especially for those for whom SORR risk is highest in the first place (those with limited financial flexibility and resources).
Timely post given how the markets are doing this past week.
The greatest strength we have is for flexibility. As you aptly pointed out, tightening the belt a little in the early years of retirement if there is a bad market will allow you to have a better lifestyle in the later years.
I started de risking last year and happy I did as I went from a big equity portion into a larger bond portion. It is easy to get complacent when the market has been going up for so long
LD, I was so excited when I saw the title. I had to go round, but before I left, I told my husband, “SORR with cash! That’s what Millennial Revolution recommended, and what I’m planning on doing, but Big ERN criticized their math. Now LD is doing it for Canadians with corporations! Amazing!”
I came home and read your article and realized that you’re actually talking about a different strategy, which I’d call a variable withdrawal rate. Wall Street Physician has a wonderful guest article about this.
It totally makes sense to me to tighten your belt or go to work if you have to. Borrowing money never crossed my mind, but it’s good to raise that as an option.
No, what I want to talk about is keeping 3-5 years in cash, out of the market. Do the numbers work? It’s hard to keep 3-5 years in cash PLUS do the rising equity glide path/bond tent, but that’s more my strategy. I think I’m comfortable with 65-75% equity in retirement.
‘Course, in the meantime, I keep working. 😉
Apologies if you already addressed this and I missed it.
Perpetual thanks for your excellent work!
Hey Melissa! I was actually thinking of you frequently as I wrote these posts given our discussions. I think that the whole notion of keeping 3-5 years as cash is simply having cash as part of your total asset allocation. Otherwise, it is just mental accounting to artificially separate it. So, if my asset allocation was normally 75% equity and 25% bonds, that could make it say 65% equity, 25% bonds, 10% cash (depending on portfolio size, spend rate, and what you sacrifice to build cash). I looked at adjusting asset allocation to attenuate SORR in the preceding post. I used bonds in that post since they dampen volatility (the real goal) better than cash in general. Also, by holding cash, you are constantly losing buying-power to inflation while bonds should generally keep pace. The upside of cash is that it is stable if bonds and equities change their pattern to not being inversely correlated which does happen sometimes. Either way, the lessening of SORR by holding cash also decreases expected returns. In the long run, decreased expected returns are another threat to portfolio longevity. An equity glide path (increasing equity or spending the cash and not replacing it) is a way to balance those two. It is most important for those with a borderline portfolio size for an extra-long retirement and inflexible cash flow (ie lean-FIRE). I personally think that choosing an asset allocation that behaviorally makes sense and sticking with it while also planning for enough cash flow flexibility in the early phase of retirement is a better approach.
Hold up! This changes EVERYTHING. https://www.advisorperspectives.com/articles/2019/01/07/does-the-bucket-approach-destroy-wealth
Well, not everything. But this is a serious shift away from keeping a percentage in cash/GIC. I can’t access the actual Estrada paper, but from the summary, and from what you and Grant are saying, my multilayered approach is decreasing my returns while only giving me the illusion of security.
I see now why you’re less interested in bonds. I won’t go that far, but it does shift me away from cash/GIC for sure.
Thanks! Much thinking (and investing) to do before I head in today.
I think bonds serve and important role. Not a big fan of cash or GICs. It is very easy for us to try and compartmentalize. May help behaviour since it is mentally soothing, but mathematically it is suboptimal.
Instead of holding 3-5 year of cash, why not just get a HELOC, preferably advanceable? Worst case scenario, you borrow money at prime and wait 3-5 years until market recovers.
On a similar note (I think), what do you think about having the above LOC and put it into market when there is a correction (like now, LOL)? It’s like doubling down for blackjack. You can get the tax write off for interest but is also at a big advantage as the market will likely rise subsequently. I think the the longest bear market lasted 5 years, but hey if you are a long term investor…
I guess the problem is deciding when to enter as the worst decline for S&P was over 50%. I am thinking going in by 20% with a 15% drop and another 30% at 20%, maybe 10% with subsequent 10% drops all the way down to 50%. Don’t know if there is any research on this.
Hey BC Doc. I agree that a LOC is an option as long as you have the financial reserve and emotional fortitude to execute.
Same with using leverage after a market pull-back along the way. It is part of my plan too. The question is at how big of a pull back does the risk-reward suit you. I am in the partial at 20% and some more at 30% camp also. It needs to be a planned and committed endeavour though. Again, having enough wiggle room that using the LOC isn’t scary is important to be able to do that.
Thanks for the post LD, I am learning a lot from you!
I am interested to know more about the wind down work by working part time idea. I have always felt that with expensive professional dues and insurance that it was not worth working part time when spending ~$15-20K in fees just to maintain license to practice.
What do other docs think about the part time work option?
That is a great question. I actually started writing about it in this post, but it was getting too long. So, I will do as a separate post. I also hope that that post will also serve as a spot for people to leave ideas and experiences.
There are many ways to do it. In my mind, the financial aspect is secondary. I would look at winding down when the money is largely a bonus. It would require working enough to offset fees and then some. Personally, I like the idea of flexible turn-key type work with less intervening responsibility. Like locums, or a casual assistant position, walk-in clinic depending on what your specialty allows. I think medical practice in a lower dosage is still a great way to glide into retirement, but there are also many non-medical encores that people can do (less overhead, but less pay).
How about the past couple of weeks eh?
How you are doing with the volatility.
Re Melissa’s question. I have worked part-time intermittently for the past 20 years now. It is fantastic. The cost to maintain my license is the best insurance I can buy for our family. If my husband can not or does not want to work, I just glide my work up.
Simple and effective.
Now that my kids are grown I want to give back more with my practice. It really has zero to do with finances after awhile.
Hey Dr. MB.
Some event like this was/is inevitable. Have weathered the volatility no problem so far. A stable job makes it much more palatable. I did have to cut my vacation short as my physician leadership job is front and centre. Fortunately, I think our province did a good job of planning for this type of thing ~2009.
Investing wise, I am actually made sure that I had no cash sitting around last week and plan to invest it this week. I am also getting close to the point where I may add in some leverage with our LOC. My premeditated plan was at a market drop of 30%. My portfolio is down about 20% currently.
I think part-time when able is a good route too. I am behind you, but just am scheduled to drop to part-time this summer.
Question: So HBB drops 9% today. Is this just due to panic selling (bid/ask spreads) or is there some risk in the bond market that I’m not aware of. VAB is also down over 3%.
Hey Jeff. Bonds have been less protective over the past week or so. I could be panic selling of everything. It could be underlying concern with corporate bond defaults. Not sure. I think panic selling of everything has been pretty prominent over the past week. The only thing that have really held up are USD relative to CAD and the Yen as a safe-haven currency. Gold has also mostly been selling off. Interesting times.
This was from a good source.
“Markets have been extremely volatile in the last few weeks, with huge intraday swings and bid-asks spreads widening dramatically. The underlying bonds in an ETF cannot be priced intraday, so I think we’re seeing some short-term distortions in the prices of the ETFs. It’s probably best to avoid any trading on days like these.”
Yeah. I think that is an issue. The market makers keep liquidity, but under pressure, they are the ones who make extra money to do so. Usually not a major issue, but the volatility lately has been insane. I noticed this on a trade earlier today. It actually got paused partway through the trade and then completed at a few percent different price a few minutes later. I generally avoid any trading in the first or last half-hour of the market day which is when most of the big trades are, but this was the middle of the day.
These are once in a decade opportunities ( as long a the market bounces back and doesn’t develop into deflation and the lost decade of Japan)
Expect this decline to go on for another 3-4 months
For the Corp account buying Brk.B, QQQ, DIA
Staying away from banks and financials due to zero interest rates
I just can’t resist some excellent quality stocks and US REITS even though they pay a dividend.
I’m limiting my annual dividend return at $25-30K
Getting V, HON, BSX, MDT, O, MSFT, UTX, LMT, BAM, BP,RDS.B ,DIS, FTS, BA
Keeping 40% in cash CMR
Keeping dry powder for AMZN, GOOG, SHW ….when they dip another 20%
Canadian dollar is crashing which will decrease my buying power
Good luck to all
I think so too. I have been buying also. This volatility will likely go on until there is clarity which will take weeks. Who knows where the bottom is or when? Could be sooner. Could be later. Either way, in the long-run we are 30% off of a peak is a good entry. 50% is better, but waiting for that risks missing the ride up too.
I have been more active than usual, but I try to just make small moves. For me, it is a balance between staying as passive as possible (where the evidence lies) and feeding my need to tinker enough to avoid pent-up energy to tinker more. I know my weakness on that one. I am still using ETFs. My US is QQQ and HULC.TO (a new one covering US Large Cap directly and is corporate class so should minimize distributions). I had sold our IJS (US Small Cap) last fall for both risk management and to buy a house. It is looking attractive to me. I did sell some of our small bonds allocation a week or so ago when rates dropped to 0.5% and they went parabolic (usually an unhealthy sign). With the cash (10% of my portfolio), I got DLR.TO which tracks the USD. Both because oil crashed and our government has been letting it whither in Canada for several years anyway despite the fact it is a major part of the Canadian economy. It was a good move so far, but successful timing requires both exits and entries. I won’t be sitting on the cash for too long. For better or worse, most of my time is currently being occupied by my ICU Chief role in preparation/management at present.
Playing catch up reading with old friends, and you could not have been more prescient, LD.
As for the glide path approach, I can only echo Dr. MB. Going out gradually has provided a financial buffer by leaving our nest egg alone to expand (or contract, this past month) unperturbed as we work just enough to cover living expenses and stop worrying about augmenting contributions. More importantly, it has redefined my relationship to work and help me fall back in like with medicine.
We opted to de-risk a few months back, and had sold some taxable orphan funds in January for a planned down payment to invest in multi-family real estate – reinforcing the wisdom of “better lucky than good.”
Stay safe, LD, and watch those aerosols.
Hey Crispy Doc. Yeah, I was planning to go softly into part-time starting this summer. However, I am currently in the thick of pandemic management with my critical care leadership job and will be leading from the front when it does hit us here. I still plan to scale back soon, but I am in for a bit of a big bang between now and then it looks like. I was also planning to downsize from my large country estate and it will take a while for the economy to recover and sell it. However, it is turning out to be the best luxury prepper’s paradise around for self-quarantine in the interim.